Capital allocations take their cue from economic conditions. So, the underlying economic conditions at year-end 2019 can help to predict the flow of capital into commercial real estate this year. Eight primary indicators determine economic growth or an approaching market correction. These include well-known metrics such as gross domestic product, employment, small-business activity and optimism, corporate earnings and bank lending activity.
In gauging the outlook, three key metrics are worthy of a deeper look as they can be the proverbial canaries in a coal mine that forewarn threats to commercial real estate investment. These include bank lending activity and income growth; commercial mortgage-backed securities (CMBS) performance data; and property prices. Each of these values continue to improve and achieve benchmarks not seen since prior to the Great Recession.
The most recent tracking data from the Federal Deposit Insurance Corp. (FDIC) on 5,303 commercial banks and savings institutions revealed strong profits and commercial real estate credit quality. Aggregate net income totaled $62.6 billion at the end of second-quarter 2019, representing a year-over-year increase of $2.5 billion, or 4.1%.
The FDIC also reported that about 60% of its institutions saw a year-over-year increase in net income, while fewer than 4% of institutions were unprofitable. The breakdown for community banks was even more promising. The net income for the 4,874 FDIC-insured community banks increased by $522.2 million year over year in second-quarter 2019, or 8.1% growth. These community banks are the backbone of commercial real estate lending outside of major cities and they typically provide the financing for smaller investment properties. In total, these bank metrics suggest that commercial real estate lending will remain stable with no contraction due to erosion in credit quality or profitability.
Bank metrics suggest that commercial real estate lending will remain stable with no contraction due to erosion in credit quality or profitability.
High performance
CMBS data also is promising. Through the first 10 months of 2019, CMBS volume surpassed the figure for the same period in 2018, according to Kroll Bond Rating Agency and Trepp. The activity level of $12.4 billion this past October brought the year-to-date issuance to $70.2 billion, up 7.8% on a year-over-year basis. The year-end pipeline for this past November and December was active as well, with potential issuance that will result in 2019 matching or surpassing that of 2018.
A more important measure than issuance, however, is CMBS delinquency. The 30-day delinquency rate fell to another post-Great Recession low of 2.47% in October 2019, according to Trepp. By comparison, the all-time high for delinquencies of 10.34% was registered in July 2012. On a property-type level, CMBS delinquency was down from a year earlier across all categories except for multifamily (up 0.19 percentage points from October 2018). The slight increase in the multifamily delinquency rate was relatively small, however, and at a level that was 40 basis points below the overall CMBS delinquency rate of 2.47%.
Meanwhile, commercial-property price growth has been moderating, a trend that will likely continue through 2020. A November 2019 report from Green Street Advisors indicated that the rate of property-value increases is slowing after nearly a decade of recovery. This flattening began in 2017 and surprisingly did not spike upward following the 2017 Tax Cuts and Jobs Act, nor downward with the onset of international tariffs. Most investors appear to be making investment decisions that are neither short-term nor deterred by tariffs. Capital is flowing into industrial warehouses and noncore property types — such as manufactured housing — and away from sectors like self-storage.
One mitigating factor to consider is that commercial real estate is undergoing an identity makeover. E-commerce warehouses are today’s big-box retail stores. Hospitality is the new retail showroom, while office space is used and rented like hotel rooms. Rental housing is more than a traditional home in the suburbs — it’s a new tiny-home development in markets such as Atlanta or Dallas; an infill subdivision where all the homes are for rent through entities like American Homes 4 Rent; or a reincarnated manufactured-home community. Green Street Advisors’ February 2020 commercial-property price index report illustrates that capital is flowing not only into malls but all property types that have been undergoing a makeover.
Among the core property types (industrial, multifamily, office and retail), industrial assets experienced the highest price appreciation over the 12-month period through January 2020 at 13%, followed by multifamily at a distant 6%, Green Street Advisors noted. Across all property types, however, manufactured housing maintained its lead for a second consecutive year with 16% price appreciation in the 12 months through this past January. Asset classes such as self-storage, health care and student housing saw annual price appreciation slow to rates of 4% or less, due primarily to overbuilding. Traditional mall and strip-center retail were among the worst-performing sectors from a valuation perspective.
Assets in major cities where REITs prefer to play are fully priced and have more downside risk at this late stage of the cycle
REIT influence
The performance and activity of real estate investment trusts (REITs) can provide useful data for commercial mortgage lenders and brokers in their investment outlook. Despite some investment groups’ perceptions of the commercial real estate cycle hitting the late stages, REITs continue to outperform most other investment-asset types (such as stocks, bonds, gold and other commodities). This is due primarily to growth in yield, resulting from both low costs of debt and rising rents, as well as price appreciation in low cap-rate and high-demand environments. Not all REITs, however, are outperforming the broader market.
This past July, National ReaI Estate Investor published its fourth annual research survey on the state of publicly traded REITs. Among the key findings in the report, there was an equilibrium between debt and equity. For a third consecutive year, 58% of respondents indicated that REITs are “balanced.” Multifamily and industrial remain favorite investment-property types.
Surprisingly, multifamily regained the most-preferred status, but only by a single percentage point. Multifamily REITs (47%) sat atop respondents’ “buy” lists in 2019, leapfrogging industrial REITs (46%), which was the No. 1 category in 2018 and 2017. The “buy” share for multifamily REITs jumped considerably from 36% in 2018, while the share for industrial fell slightly from 49% in 2018.
Multifamily and industrial were the most in-demand property types, but it’s not surprising that retail was the asset class most REITs prefer to sell. These divestments may represent an overlooked opportunity. Retail assets can still be valuable for the savvy investor.
The surveyed REITs also reported that capital is plentiful. Debt remained the preferred source of capital due to historically low interest rates. The outlook on whether REITs plan to expand, stand pat or shrink their portfolios is unclear. Thirty-five percent of respondents believed REITs would maintain their investment levels for the remainder of the year, with 28% indicating REITs would be net buyers and 17% saying they would be net sellers. One-fifth of respondents weren’t sure what REITs would do.
The consensus view of REITs serves to inform mortgage brokers and lenders of the general trends in commercial real estate. Assets in major cities where REITs prefer to play are fully priced and have more downside risk at this late stage of the cycle. Second, assets and portfolios are hard to find, so the best strategy may be to focus on enhancing or repositioning existing portfolios to increase their overall financial performance. There also is a bias toward multifamily and industrial portfolios versus a broader spectrum of asset types.
